Market Set to Turn Up?

I’ve been watching half a dozen indicators for the past eight weeks. At first I was expecting them to signal an “all-clear” so we could jump back into the market. Optimism gave way to anxiety, however, and now I’m looking for them to signal that the upcoming Recession will, eventually, be followed by a recovery. The alternative – something worse than a Recession – is too frightening to name and not yet off the table.

• High Yield Bond rally

High yield bonds are often the first thing to turn up during a recession. Alas, I’ve been waiting for high yield bonds to rally since last February. Finally, during the week of December 15, junk bonds began to show signs of life.

• Oil Price rally

Lower oil prices help the consumer, but $35 oil also indicates a severe slowdown in global economic activity. Gasoline prices at $1.50 per gallon leave more discretionary spending power in the hands of folks who live paycheck to paycheck (these days, that’s about everyone). However, these low prices also discourage investment in energy supplies, renewable and alternative energy industries, and global capital spending. The global economy runs on oil. If the globe shuts down, $35 oil probably makes sense. I’m hoping that the global economy keeps working and a more robust demand for energy develops. I will gladly pay $2 per gallon if it means that we’ve avoided a worldwide bust. Fortunately, the energy industry seems to be more optimistic than the folks setting spot market prices. Oil futures for long-term delivery (out a year or more) are pricing oil around $50, and the majors are filling up tankers and parking them in ports around the world, convinced that prices will be higher down the road. I truly hope they’re right but at the moment, falling oil prices are waving a huge red flag for international investors.

• Banks start lending

Money keeps piling up on deposit at the Federal Reserve. Yesterday the Fed reported that total reserves have grown from $43 billion last summer to almost $828 billion this week. Bailout funds and a flood of new deposits are getting sucked into our black hole of a banking system and we taxpayers, via the Federal Reserve, continue to pay banks interest for the lenders who’ve stopped making loans. Think of it as a “job bank” for the pinstriped suit set.

Bank regulators are changing the rules, making it more difficult for banks to lend on real estate. Even existing projects with current cash flows may not be bankable on their own merits. The cow is gone and the regulators have securely locked the barn door, just in time to prevent a recovery. Main Street is paying for the mistakes made by the really smart guys whom Alan Greenspan trusted to know what they were doing. His bad.

• Bond market starts working again

For things to really get back to normal, the high yield bond market needs to be a viable place for companies to make money again. To avoid a depression, the high quality bond market needs to be functioning. Fortunately, finally, in recent weeks the high grade market has begun moving back to almost normal levels. Though yield spreads compared to Treasury bonds are still wide, part of the dysfunction is in the treasury market, not in the world of corporates. The broad bond market exchange traded fund (LQD) started the year around $105, and fell to $76 during the recent market turmoil, has recently recovered to almost $99. Much of the progress has come in the last week. This is a very strong signal that at some level, the capital markets are starting to function again.

• Volatility declines

The VIX index is a measure of intra-day price swings in the stock market. It increased 8-fold as the bank panic unfolded, resulting in swings in a single day that are nearly equal to an entire year’s typical performance. No one is comfortable investing when the market soars or plunges 10% in a day. The VIX has started to decline. It is nearly half of what it was at the peak of the crash, though it remains double or triple normal levels. As volatility continues to decline, stock valuations should appreciate.

These are five of the indicators which I’ve been watching for the past two months. I really thought that they would have turned up…in late October. It is extremely worrisome that they took so long to begin to improve – and in some instances still haven’t improved much. The excessive volatility and anxiety, and the lack of available capital in the system, is much like the economic “heart attack” that Warren Buffett described in his Charlie Rose interview. These things are causing damage, even today. The more damage we suffer, the longer it will take to turn things around.

We remain short-term optimistic. Especially as this week came to a close, the market looks capable of sustaining a rally. Psychology couldn’t get much worse. I would normally be pounding the table, encouraging investors to buy stocks.

The economic fundamentals, though, remain really bad. My economic weather forecast is for current weakness, with not much hope of a turnaround in the future. The stock market can rally, even if economic fundamentals continue to decline. As credit continues to ease, which I continue to think and hope that it will, we should gradually move past fears of a depression and onto a different set of expectations. That will help the rally in the short run.

When we get that rally, investors need to take a gut check. Are you really long-term investors? Are you really willing to risk another 40% decline in order to get the upside from stocks that is available to long-run investors? Cashing out, at that point, will still require accepting a loss for many investors. For some, however, it will be the right thing to do. Others will hang in there with me, for better or for worse, in order to try to take advantage of the profit opportunities that arise from volatile markets. It won’t be an easy call and investing in 2009 (and 2010?) will require more imagination than usual.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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